[Microsoft changed its ESPP terms in May 2004 so below analysis is no longer valid. Please read this updated analysis for the new ESPP terms.]
Microsoft Employee Stock Purchase Program (ESPP) has attractive features to promote MSFT stock ownership among the employees. I always recommend to participate in ESPP program at the highest percentage allowed (15% of salary income & bonus), and to sell ESPP shares as soon as it is possible ("immediate sale").
BASIC TERMS OF MICROSOFT ESPP
- One ESPP period is six months (Jan 1 to Jun 30 and Jul 1 to Dec 31)
- Before each ESPP period, employee can assign a percentage that Microsoft will withhold for the program. This percentage applies to pre-tax income, but the money is deducted from after-tax income. Employee can suspend contribution or ask money back during most time of the period.
- Stock will be purchased on Jun 30 or Dec 31. The price will be 85% of the lower of closing price of the first trading day and closing price of the the last trading day.
- Employee can sell the shares immediately, though holding the shares for at least 18 months will have some different, and maybe beneficial, tax treatments of income.
FINANCIAL MODELING OF "IMMEDIATE SALE" STRATEGY
The ESPP share is usually available for sale around one week after the last period closes. Assuming that the prevailing marketing price when the stock is up for sale is the same as the closing price of the last period, then the gain from the immediate sale strategy will be:
Absolute Gain = 1 / 0.85 - 1 = 17.65%
After Tax Gain = 17.65 * (1 - 25%) = 13.24%
* assuming the marginal tax rate is 25%
Average months of cash tied to ESPP in a period = (6 + 5.5 + 5 + 4.5 + 4 + 3.5 + 3 + 2.5 + 2 + 1.5 + 1 + 0.5) / 12 = 3.25 months
* Microsoft pays biweekly at around 15th or 30th. Also sale proceeds from ESPP is available at around Jan 15th or Jul 15th if employee sells the share immediately.
Annualized After-Tax Gain = (1 + 13.24%) ^ (12 / 3.25) - 1 = 58.26%
TAX TREATMENT DISCUSSION
The immediate sale strategy will render most of the gains as ordinary income (taxed at personal marginal tax rate). The capital gain/loss part should be very small if there is no volatile stock price change in the first week when a period ends. This is usually the case as Microsoft will issue quarterly earning release around Jan 20th or Jul 20th, so the first week after an ESPP period ends is usually the "quiet period" for Microsoft. Unless there is a market upheaval (another September 11, for example), there may not be big price fluctuation.
The perceived tax benefits from a buy-and-hold strategy for ESPP shares are illusive. In short, buy-and-hold ESPP shares for more than 18 months will subject the difference between the ESPP purchase price and the then-prevailing market price as ordinary income, and any other income/loss as long-term capital gain/loss. (Long-term capital gain is taxed at a rate of 15% at most. Long-term capital loss can be used to offset short-term capital gain if there is no long-term capital gain to offset.) Also the ordinary income portion is not subject to tax until the share is sold.
The best scenario is MSFT will rise above the Jan 1st or Jul 1st price after 18 months. This will save 10% tax for the capital gain part. However, barring substantial move of MSFT (which is near to impossible in my view as Microsoft is a huge company now), the capital gain part is very minimal.
Also, the delay of tax on the ordinary income part is only worth employee's cost of capital, which can be only 2% if the next-best choice is to put into a saving account.
My ESPP strategy since inception is always contributing the most (15%) and immediately sell ESPP shares as soon as possible. I believe this is the best strategy for most people because:
- Almost guaranteed 58% annualized return. (This means if necessary, people will be better off accumulating reasonable credit card debt and contribute the most to ESPP.)
- It only ties 15% of pre-tax income for an average of 3.25 months so it minimized cash flow issues in personal finance.
The shortcomings for the buy-and-hold strategy are:
- 15% of pre-tax income is tied to ESPP for around 21 months (3.25 + 18) for some probable tax benefits. This may create some cash flow problems if employee also wants to contribute to 401(k) and Roth IRA accounts.
- The tax benefits of buy-and-hold strategy is illusive and, at best, small. Sometimes (in the downturn) buy-and-hold will backfire (tax on the ordinary income needs to be paid anyway, and employee may have too much capital losses that cannot be used for a certain tax year -- annual capital loss limit is $3,000)
- This will make personal portfolio over concentrating on MSFT (as most employees also hold lots of MSFT stock options)